This article originated because of differences of opinion among Texas appraisal districts, taxpayers, and their representatives relating to the reliability of the commonly used mass appraisal income approach model. It examines the elements of the model, presents associated problems, and provides a suggested resolution.

Three Tests to Determine a Fair Value: An Example from Texas

by Paul Pennington

This article originated because of differences of opinion among Texas appraisal districts, taxpayers, and their representatives relating to the reliability of the commonly used mass appraisal income approach model. It examines the elements of the model, presents associated problems, and provides a suggested resolution.

THE TEXAS CONSTITUTION sets out five rules for the property tax. Taxation must be equal and uniform. All property must be valued and taxed equally and uniformly. This applies to similar types of property-for example, all residential homes, commercial properties and personal properties. No single property or type of property should pay more than its fair share of taxes.1 Sometimes, the methods used in the past must be reexamined and tested to achieve equal and uniform taxation. This article originated because of differences of opinion among Texas appraisal districts (districts), taxpayers, and their representatives relating to the reliability of the commonly used mass appraisal income approach model (the model). Although this approach provides districts with a standardized analysis and is direct and systematic, it is, in the opinion of some, inconsistent. An examination of the district's model illustrates the fundamental differences of opinion in the definitions and application of three major components needed to secure market value assessments. The areas of disagreement revolve around the use of market value sales data, the application of the fee simple estate ownership, and the fairness and equality of valuations.

The Model

In the normal course of a valuation review, the district examines the property's December 31, 12-month profit and loss statement and the January rent roll. They generally use a model whose result is determined by these steps:

1.The January rent roll and the most recently signed leases or lease. By using these leases, an aggregate rate is arrived at as of January 1-one rental rate being applied to the entire property. Another method is to use the district's defined lease rate by applying mass appraisal standards

2.The district's market vacancy is deducted

3.The district's standards for operating expenses, generally with no allowances for reserves, tenant finish out, or leasing commissions, for example, is deducted

4.A net operating income (NOI) on the subject property is calculated

5.A standardized capitalization rate that districts have determined is reflective of the market, property class, and age is applied, which in their opinion, results in a fee simple market value

In all fairness to districts and their staff, they do not, as a policy, limit themselves to the income approach to value. Generally, they give consideration to additional information, such as recent appraisals, purchase prices, asking prices, the sales comparison approach, and the cost approach to value.

THE PROBLEM

To determine a fair value, commonly accepted valuation techniques, such as the sales comparison, income, and cost approaches should be considered, and then the most appropriate method used. However, because this article revolves around property tax valuations, the valuation should use a test consisting of three tax components to avoid an incorrect result. The components, as previously stated (i.e., market value, fee simple estate, and fair and equal taxation) make up the analysis of property to determine a fair valuation. The following paragraphs review some commonly used terms.

The first term to understand for property tax purposes is market value. The Texas Property Tax Code (Texas Code) requires all property to be appraised at market value as of January 1 of each year. The Texas Code defines market value as follows:

Market value means the price at which a property would transfer for cash or itsequivalent under prevailing market conditions if:

1.Exposed for sale in the open market with a reasonable time for the seller to find a purchaser;

2.Both the seller and the purchaser know of all the uses and purposes to which the property is adapted and for which it is capable of being used and of the enforceable restrictions on its use; and

3.Both the seller and purchaser seek to maximize their gains and neither is in a position to take advantage of the exigencies of the other.

A fee simple estate is defined as: "Absolute ownership unencumbered by any other interest or estate subject only to the four powers of government." The fee simple estate is divided into several components:

1.Leased Fee. The lessor's interest, the right to receive the rent as stipulated by the lease, and the reversion of the property at the expiration of the lease

2.Leasehold. The lessee's interest and the right to use and occupy the real estate during the term of the lease, subject to any contractual restrictions. The leasehold may include rights to develop, alter, or sublease, for example

As previously mentioned, the Texas Constitution states that taxation must be equal and uniform and that all property must be valued and taxed equally and uniformly. In addition, no single property or type of property should pay more than its fair share of taxes.

Consider, on the surface, some of the problems a knowledgeable investor might have with the district's income model described above. Furthermore, recognize that the model is simply, in reality, a pro forma, a projection of the property's future net operating income (NOI). Forecasting a property's performance is difficult and is not conducive to mass appraisal techniques. It is difficult to predict all the ups and downs of a property, the real estate industry, and the numerous external factors that can affect property. Therefore, it is difficult to predict the performance of a property. Due diligence must be used in the model's forecast.

To begin with, the methods to determine market rental rates should be considered. The approach might be standardized; however, it is generally not based on intimate knowledge of each property's individual lease property, nor is it usually confirmed by comparable market leases. It can be argued that using the model's technique to determine a single rental rate for an entire building creates, in theory, a single tenant property. Having a single tenant building can be looked at in the same manner as an investor owning one stock. Extending this analogy, an investor with a multi-tenant building might be the same as an investor with a diversified investment portfolio. Thus, a single tenant property could have more risk than a similar multi-tenant building. This possible increased risk is reflected in the capitalization rate that is discussed later. Moreover, the model does not consider income appreciation, depreciation, or the effects of inflation. The same arguments can be used in predicting the occupancy rate of a property.

Using the district's standards for operating expenses and not making allowances for reserves, tenant finish out, or leasing commissions, is not typical for a knowledgeable investor. An investor also considers the operating expenses of like properties in the subject's neighborhood or submarket. Considering the arguments noted above, it is questionable if the NOI derived from the district's pro forma is accurate.

At this point in the review of the model, additional areas of concern appear. Now, the concepts of fee simple and leased fee estates come into play. Contrary to the district's position, its approach assumes that a knowledgeable investor uses a leased fee capitalization rate when buying a property on a fee simple basis. The market place reveals that a knowledgeable buyer is counting on income appreciation when purchasing a leased fee estate. The model noted above relies on the assumption that an aggregate lease rate (which averages three to five years lease term depending on property type), as well as the district's stabilized occupancy rates, apply to the property. In other words, it is assumed that the property will maintain these lease rates and occupancy levels throughout the year for purposes of taxation. This, in the opinion of some, creates a dilemma. These problems are explained by Jeff Tarpley, MAI, with the Dallas appraisal firm of Butler-Burgher, Inc., in the following excerpt from a recent fee simple appraisal:

...This method involves capitalizing the stabilized net operating income (NOI) by an appropriate capitalization rate (Ro) in order to estimate the stabilized value of the project. Ideally, the Overall Capitalization Rate (Ro) utilized in Direct Capitalization is typically derived from comparable sales. Income producing properties subject to existing lease(s) are normally purchased on the basis of actual rents at the date of sale (leased fee estate). However, the subject is being appraised on a fee simple basis (subject to market rent at the date of valuation). The overall rates derived from existing rents at the date of sale (leased fee) are much lower than those derived utilizing market rent (fee simple). Mathematically, this is attributable to market rent being higher than existing rents; consequently, the resulting overall rate should be higher. With regard to appraisal methodology, this is a reflection of the risk inherent in attempting to achieve market rents when there are higher than actual rents at the date of sale. For example, tenants may resist paying the higher rates and vacate the property. In addition, the landlord may have to offer tenant finish out and other concessions above those offered in the past in order to lease the building at higher market rental rates.

If the Texas model is to be accepted, a higher capitalization rate must be considered. The higher rate takes into consideration the increased risk of the owner because the model leaves no room for an increased risk factor or appreciation of the income stream over the investment period in an efficient market. Thus, it has a negative effect on the owner's leased fee taxpayer. Furthermore, there is a risk of a dip in the market rental rates during the investor's holding period. For example, if the building is tied into high rental rates and the market shifts downward, the tenants have three options:

1.Stay through the term of the lease and then renegotiate a new market lease with the landlord.

2.Try to buy out of the current lease and move to a new building with lower market rates.

3.Break the existing lease and move.

Another facet of the problem from the taxpayer's point of view is the question revolving around market value, fee simple estates, and fair and equal valuations. For example, as a matter of procedure, if a taxpayer were to bring as evidence a recent, arm's-length multi or single-tenant market value sale, the districts normally accept the sale and make the appropriate valuation adjustment. Now, consider, under this situation, that the sale used by the taxpayer pertains to an income producing property. Add to this scenario that the subject property is a leased fee sale in which the property is bought based on its existing income. Does this property meet the three areas required by the Code and the Texas Constitution to be a market value fee simple valuation that is also fair and equal? Most might agree that using a leased fee sale to obtain a reduction of a valuation is contrary to the determination of a correct value pursuant to the Texas Code and the Texas Constitution.

Under the scenario described earlier, the leased fee sale could meet the definition of a market value sale. However, there is a need to recognize it as a leased fee market value sale. This does not meet the criteria of being a market value fee simple sale for property tax purposes, failing the first test of "fair value." Therefore, the notion of fee simple ownership must be added when using market value sales and/or capitalization rates. Over the years, Texas courts have defined market value based on fee simple. The latest cases, for example, Cherokee Water Co. V. Gregg County Appraisal District2 and Dallas Central Appraisal District V. Jagee Corporation3 have reaffirmed this approach.

The origins of fee simple estate ownership come from the medieval idea that, in England, based on common law, all land was owned by the monarch. Thus, no one technically owned land outright, as it was on loan from the monarch. They were allowed to hold these estates by the authority of the monarch. Today, after gaining private ownership from the monarch, the question: "What is a fee simple estate?" can be answered.

In other words, a fee simple estate deals with ownership, whereas earlier, the market value component deals with the valuation of property. The Texas Code and courts reveal that when using generally accepted appraisal techniques, the need to make adjustments to income data, sale comparisons, and costs components must be assumed to make them comply with the definition of a fee simple estate. For example, fee simple adjustments should be considered for sales comparable, capitalization rates, and market leases, as previously noted by Jeff Tarpley. It is known that districts and most protesting taxpayers do not normally use such information. They generally use leased fee sales or capitalization rates, for example, without making adjustments to estimate a property's fee simple ownership value versus the subject's leased fee interest value. Clearly, leased fee closing statements are used to obtain tax reductions on a daily basis. Thus, in most cases, using a leased fee closing statement fails the second test of determining a fair value, because of the lack of a reconciliation to reflect the property's fee simple market value.

Note that market value on a fee simple basis may not result in the highest value for taxation purposes. An illustration is a market in which leased fee interests parallel those of fee simple. For example, ". . . assignment is to estimate the market value of a fee simple ownership interest. Appraisers also study markets for real estate space, identifying supply and demand relationships and tracking the activity of market participants to develop value estimates consistent with the definition of market value. The specific form of ownership may or may not be relevant to the final value conclusion." This is an interesting concept in the market value fee simple approach as it relates the Texas Code and courts mandated method of valuation in Texas. Another example is ". . . Dividing real property into a large number of partial interests results in the syndicator realizing a gross price greater than could have been realized from a sale of the 100% interest to a single purchaser. Thus, the sum of the parts can be greater than the whole." Yet another example involves a down market in which a property's leased fee estate has older leases that are higher than current market rents. Thus, the value of the leased fee estate is greater than that of the fee simple estate.

Therefore, the question that begs to be asked is one of equality and uniformity. One taxpayer gets a better appraised value by using a leased fee closing statement, and another, by using the districts income model, gets perhaps a higher valuation. This results in an unfair and unequal value for the taxpayer using the model. In Texas, property must be valued equally and uniformly, but this does not necessarily occur. Thus, it appears on the surface, that under the original scenario, the property in question fails the third test of obtaining a fair value. This assumption may not be correct based on the following guidelines required by the Texas Code that cover the procedures to establish inequality of an appraised value:

1.A reasonable and representative sample of other properties in the appraisal district

2.A sample of properties in the appraisal district consisting of a reasonable number of other properties similarly to, or of the same general kind or character as, the property subject to the protest

As of January 1, 1996, the Dallas Central Appraisal District (DCAD) appraised 768,258 properties. These properties include commercial real estate, residential real estate, and personal property. Districts use statistical testing (i.e., state mandated ratio studies) to determine how close to 100 percent market value their values are as of the first of the year. Even though the methodology used by all appraisal districts is standardized, is it possible to determine the market value of 768,258 properties as of January 1? Most professionals agree that the use of leased fee sales in ratio studies results in inaccurate tax rolls. Certainly, this topic is compounded by the issues of market value on a fee simple basis as discussed previously. The 1997 legislature has eased significantly the number of comparable properties needed for an appeal based on an equal and uniform issue.

CONCLUSION

In an attempt to determine a fair value pursuant to the Texas Code and the Texas Constitution, professionals must not assume that an income-producing sale constitutes a fair value. It may very well constitute the market value of a leased fee estate, but not market value on a fee simple basis. It should be recognized that the model must include market and fee simple components, including comparable rental rates, occupancies, operating expenses, and fee simple capitalization rates, which as previously discussed, should be higher than leased fee capitalization rates. These higher rates are the result of higher risk factors, along with the loss of income and value appreciation. Finally, using leased fee sales and capitalization rates does not appear to be equal and uniform to other taxpayers' using the Texas model.

In attempting to determine a fair valuation for a taxpayer, the three tests relating to market value, fee simple ownership, and fair and equal taxation must be addressed. If one or all of these tests is ignored, the taxpayer will most likely end up with an incorrect value. Furthermore, the changes to the Texas Code relating to the protest of unequal appraisals and the use of the Uniform Standards of Professional Appraisal Practice now place the burden of proof on the districts, and other changes should improve the quality of many appraisal rolls. However, oversight of the issues discussed in this article may result in tax rolls being flawed and subject to taxpayer appeal.